Ken Rogoff: 'It really boils down to arrogance and ignorance'

In their book “This Time is Different,” Carmen Reinhart and Kenneth Rogoff construct the richest and most detailed history of financial crises that anyone has developed. Their data set covers 66 countries, five continents and eight centuries, and gives them an unparalleled ability to see patterns and predictors amongst different types of crashes. And see them they do. I spoke to Rogoff about the causes, trajectories and solutions to financial crises earlier today. A lightly edited transcript of our conversation follows.

Your book has a much larger data set of financial crises than anyone had previously assembled. And my understanding is that you actually built that data set before our crisis hit. So how did having access to all that historical information change the way you understood our financial turmoil?

We had the major charts and tables ahead of the crisis. The key charts in Chapter 13, for instance, were published before the crisis and said the U.S. was at high risk for a crisis based on virtually every available indicator. And the main prediction we made in our work was that deep financial crises are different than typical recessions. It takes longer to recover from a financial crisis. So those economists who had just studied the handful of previous U.S. recessions and used those to benchmark everything – that is, the overwhelming majority of forecasters --- missed the boat because this kind of recession really is different.

Some of your work argues that financial crises often lead to debt crises.

Our database has historical debt data across over sixty countries. This allowed us look at what happened to debt after other financial crises. And debt explodes, nearly doubling over three years – which, in turn, can lead to sovereign-debt crises. Some of the crises occur in the epicenter countries where the government did everything possible to save the financial sector but couldn't afford it. Sometimes sovereign debt crises happen in peripheral countries that are hit by volatility and rising risk aversion, like what's happening in Greece.

Has our financial crisis fit the pattern of other financial crises, or was it somehow different?

In many ways, our experience has been a garden-variety post-war deep financial crisis. The recessions from financial crises typically last a year and a half, and that's about what ours was. With the notable exception of Japan, equity prices tend to bounce back reasonably quickly, and that's happened with U.S. stock prices. We probably came back a little faster. The main way in which this crisis is different from other post war crises, however, is that it was global. And that adds an important dimension to it. The Great Depression was global and there were global crises in the 1800s, but they're not common. And global crises are more worrisome because a major way countries get out of these crises is exports. But in a global crisis, not everyone can ramp up exports all at once.

Has looking at other financial crises changed your perspective on how ours began? That is to say, was this really a predictable event, or did we go through a unique problem that became a common crisis?

As Carmen Reinhart and I have emphasized, it really boils down to arrogance and ignorance. Across the huge range of crises we look at, the similarities are remarkable. Countries have different policy responses, central bank systems, political institutions and financial systems, but they share the quantitative markers that precede these crises: Run-ups in housing prices and huge leverage are major indicators. So the people who think this was all about Lehman haven't read our book. This wasn't about some mistakes made over one weekend the way many books portray it. Housing prices had doubled, debt had exploded, we were set to lose trillions of dollars in the value of our capital stock. Lehman was the spark, but the idea that it could've been largely avoided is very naive. If people think that the only real problem was letting Lehman fail, then that bodes badly for the steps we'll take to prevent future crises.

You mentioned arrogance and ignorance. What do you mean by that?

Our title is ironic. Countries are often in the middle of these huge, speculative bubbles, and yet even the smartest people who know there have been these accidents in the past convince themselves that they won't have the same problem. In the recent crisis, the excuse was, this time, we have global financialization, better monetary policy, rocket-science finance and China. But the system still couldn't take the stress.

The conclusion of your book was a bit depressing on this point. You said that there are indicators we can watch to predict when we're vulnerable to a financial crisis, but in general, the problem is that policymakers explain the indicators away. Information, in other words, is not enough, because people create stories to explain the information away.

Start with a really important point: It's very hard to call the timing of a crisis. You can see that an economy is vulnerable, and maybe even fairly reliably say you'll have a crisis in 5 to10 years, but until it's upon you, it's hard to narrow the window down with any precision. Many of the people who say they predicted the crisis in a precise way had actually been predicting a crisis for years. There's irreducible uncertainty coming from fragile confidence and political factors. The analogy is someone who's vulnerable to a heart attack. You can go to the doctor and they can see your cholesterol is high and you have a number of risk factors, but you might go on for 20 years without anything happening. Or it might be 20 hours.

Because the timing is hard to call, policymakers have trouble getting seized by it. Why worry if it is not going to hit on my watch? And if you're an investor and you're making great money for five more years and then you have a bad year, you still have a good decade. But policymakers, especially, need to have a longer vision because of the human cost of financial crises, particularly in the hugely elevated level of long-term unemployment.

So how do you defend against them? Your book made me very skeptical that regulators, even with better information and more power, will prove sufficient in the future. Arrogance and ignorance are human failings, and even very good regulators are still human beings.

You need several levels of defense. To depend excessively on regulatory judgment would be really naive. The banks and financial institutions are very clever at staying ahead of the regulators. A big problem there, though, is that regulators don't get paid enough. I watch star regulators and analysts get bid away by the financial firms all the time. You can't have people regulating these hundred-billion dollar firms who are paid less than executive secretaries at the firms they're regulating.

We found that crises occurred at remarkably regular intervals, we are talking about 30 or 40 years apart. This last crisis will be etched in our memories for some time to come, but in due time, those memories will fade and a new generation of successful investors and politicians will come along who underweight the risk.

What are the several layers of defense you'd like to see?

Among academics, there's quite a debate about this. I wish there was a consensus, but there isn't. One school of thought says “let’s keep things simpler in the financial world.” Have derivatives traded in open markets and use capital requirements and other measures to keep financial institutions from becoming excessively leveraged. Put in place reforms to keep financial institutions simple enough that investors and regulators actually understand them. Another school of thought says we have too little financial innovation and we need to introduce new ideas like better forms of contingent capital and if we did that, it would solve the problems. I tend to think it's important to have a relatively clear, transparent system, with ideas like contingent capital playing a secondary role. But there isn't an easy consensus, which complicates the task for policymakers.

With that in mind, what do you think about the financial regulation proposal that Congress is about to pass?

To be honest, the bill leaves a lot in the hands of regulators. Whether they'll have the knowledge, tools and ability to be successful even if the system remains so complex, is a big question. There are good ideas in there, like pushing derivatives onto open markets with prices. But I've been struck that my colleagues who have examined the legislation most carefully seem the most skeptical. For example, many are skeptical as to whether too-big-to-fail will work. Will we really invoke prophylactic bankruptcy proceedings in time? Financial regulation is complicated and involves a lot of judgment, information and politics. In the short run, the legislation will work simply because everyone is so punch-drunk and crisis wary. But over the longer-term, as memories of this crisis fade, it's hard to say if this will be enough.

It seems like the ignorance and arrogance are secondary to more fundamental realities of complexity and uncertainty. Financial crises are going to happen, so we have to be able to mitigate and contain them. Hence resolution authority, capital requirements, etc. And a little humility in the markets would help.

I often wonder what Alan Greenspan would do if he could go back, knowing what he knows now, to, say 2003. Would he announce that we are in the midst of a major bubble and heading toward crisis? If he triggered a correction, he would be blamed for sabotaging our recovery and creating a self-fulfilling prophesy. Or the markets might just have ignored him, like they ignored his "irrational exuberance" speech. Either way, a tough situation with no easy answers.

Good interview. One indicator of the housing bubble was people taking out loans they could not possibly repay unless housing prices continued to rise. Most rube have no idea how much loan they can reasonably repay. When the loan sharks can lie to the public with impunity, therein is most of the problem.

The focus of any financial regulation needs to be on consumer protection. Would there have been a big housing bubble if regulations were in place to prevent liar loans and other kinds of consumer loan shark fraud?

The health analogy is instructive. Think about all the people who think that they are exceptions to the statistics about blood pressure, triglyceride numbers and so forth. And also think about what it costs to do pre-attack interventions versus a bypass or a transplant or paying out on life insurance.